The Big Short Squeeze
Overview
From GameStop, an intrinsically weak stock, surging over 19,000%, to Wall Street hedge funds losing over 80 billion USD, and finally, Elon Musk, Donald Trump Jr., and AOC joining hands against the brokerage, Robinhood, a lot has transpired pertaining to the financial world within the past week. For the “madlads” at the subreddit r/wallstreetbets, it’s been a rollercoaster ride too – with some members turning $53,000 into over $40,000,000, while others using their modest gains to fulfill mortgage and education obligations. What materialized was a spectacle to witness, and this blog seeks to scout through the intricacies of these events while yielding useful explanations for the same.
r/wallstreetbets
For starters, let’s talk about r/wallstreetbets, the Reddit community that managed to beat Wall Street. The subreddit is essentially an army of about 2 million (4.5 million following the incidents) traders who seek to “yolo” their life savings into “meme stocks”. The quintessential WSB “madlad” is slightly over 18 years of age and pumps money (student loans) into meme stocks while attending Econ 101 lectures on Zoom. The subreddit favorites are Tesla, GameStop, AMD, NVIDIA, and more recently, AMC, Blackberry, and Nokia. Other asset classes include a heavy interest in cryptocurrencies, primarily Bitcoin and DogeCoin. The subreddit is also known for betting money on esoteric financial derivatives like options and futures, with a soft spot for out of the money, near expiration call options. WSB has previously demonstrated its market might by single-handedly skyrocketing Hertz shares to over 900% (after the company filed for chapter 11 bankruptcy), fuelling Tesla rallies, and sending DogeCoin prices to the moon. Most of the users execute through Robinhood, the subreddit’s (former) loyal brokerage.
GameStop and Shorting
GameStop, the robust brick and mortar video-game retailer, has been struggling with sales following the transition to online gaming, furthermore, their financial turmoil was exacerbated by the pandemic. To provide financials, GameStop’s revenue for the quarter ending October 31, 2020, was $1.005B, a 30.16%YoY decline. With piling debt and plans to shut down over 1000 stores, (in addition to the 700+ stores already closed) GameStop stock ($GME) has observed significant short-interest with their short float (% of all outstanding shares being short) being as high as 140%.
For a shorting 101, a short position is basically a trade that benefits the investor when the price of a security declines. To profit off a rising stock, an investor simply buys it. To profit off a declining stock an investor shorts it. To elucidate –
Let’s say a monkey holds 10 bananas and each banana costs $10. A snake who believes that the price of the banana might fall in the near future comes up to the monkey and borrows the 10 bananas. The snake then immediately sells those 10 bananas in the market cashing in $100 hoping that they might be able to buy them back for a cheaper price.
Scenario A – Let’s say that the price does fall to $5, the snake then buys back all the bananas (this is called “covering” the short) for $50 and gives them back to the monkey, through this trade the snake pockets the difference (100-50) which is $50.
Scenario B – Let’s now assume that contrary to the snake’s belief, the price of one banana goes up to 15$. Eventually, the snake has to give back the borrowed bananas and is forced to buy back the 10 bananas at the prevailing market prices. The snake buys back the bananas at $150 (again, “covering” the short) and returns them to the monkey. In this trade, the snake loses a total of $50, which they pay from their own pocket.
To now explain the 140% percent short float, let’s say that some of the bananas that the snake sold made their way back to the monkey, who lends them further to another snake, who in turn sells them in the market. So, what we observe here is a shorted banana being shorted again and again.
Now, just replace the banana with a stock, the monkey with a broker, and the snake with an investor, and we have the market structure of a short position.
Subsequent to the dismal financial performance of GameStop many hedge funds started to heavily short the stock. When a share is shorted, it is essentially borrowed and sold in the market. Heavy selling increases supply over demand, and the stock witnesses additional deflationary pressure.
Following the short interest, GME gradually fell from $45 in late 2015 to $2.8 by mid-2020 and hedge funds bagged huge gains.
The Saga of Reddit and GME
The question then arises, what sparked Reddit’s interest into the evidently dead stock?
Well, in August 2020, Ryan Cohen, co-founder of the online pet supplies retailer, Chewy, acquired a 9% (now 12.9%) stake in GameStop intending to expand the business into an e-commerce giant. Additional investments by James Symancyk, former CEO of PetSmart, and a strategic partnership with Microsoft to facilitate the growth of both the online and physical retail facets of the business renewed hope and sent GME shares up 28%.
With promising growth prospects and upcoming console launches, Michael Burry acquired a 2.4% stake in the business, piquing retail interest into the stock.
This is where Reddit comes in. WSB perceived the recent GME momentum as an opportunity to help revive the inseparably nostalgic business. Reddit users soon discovered the seemingly high short float and scrutinized the potential to initiate a “short-squeeze”.
Short-squeeze 101 –
Recall the snake borrowing 10 bananas from the monkey and then selling them in the market. Now, if all the monkeys notice what the snake was trying to execute and in-turn decided to BUY and HOLD all the bananas, then the snake would eventually have no choice but to buy the bananas from the monkeys to cover the short. Since the monkeys hold all the bananas in the market, they dictate the price. In this situation, the snake has no option but to pay the price demanded by the monkeys.
Just replace the snake with Wall Street hedge funds and the monkeys with Redditors to structure the GME short-squeeze.
Gamma-squeeze 101 – This is an intricate concept but has repercussions similar to that of a short-squeeze. In the markets, shorts may buy financial derivatives, specifically call options to hedge potential risks of their short positions failing. Just think of these derivatives as an “insurance” against a short position. Call options are purchased at a “premium” which takes away from the potential gains the shorts might have. As the price of a stock rises, the shorts buy more and more call options for the share to minimise losses, this increases demand and supplements the ludicrous rise of the stock.
Redditors theorised that if they bought all the outstanding GameStop shares floating in the markets, increased demand would not only push prices up, but as prices climbed hedge funds short on stock would have to cover to mitigate losses. To cover they would approach the markets (remember, theoretically the market is just Redditors) who will refuse to sell and instead, will hold. Therefore, the intertwining of extremely high demand and terribly low supply would ultimately transcend into a “squeeze” (short-squeeze and gamma squeeze) sending GME prices through the roof.
Turns out the culmination of negative pressure on a nostalgic stock, anti-WSB tweets by shorts, support from Elon Musk, and boredom market hypothesis front-running the markets was all that was required to trigger an army of retail investors. Led by WSB, they executed the squeeze and facilitated the parabolic rise.
GME experienced unprecedented trade volume starting January 13, 2021, opening at $20 and reaching a high of $38. As days passed the swift climb continued, eventually reaching the meteoric highs of above $300 on January 27 and 28. YTD (Jan 4 – Jan 27, 2020) the share is up 1,914.55% that’s more than a 20x gain.
The Redditors didn’t “stop” there, they scoured the markets for more stocks with high short-floats and “yolo’ed” more of their life savings into them. AMC Entertainment, Blackberry, and Nokia fit the bill for nostalgic and historically significant businesses with heavy short-interests and therefore, experienced similar surges.
The Shorts
The shorts, primarily Citron Research and Melvin Capital, were simply out-volumed. Citron was forced to cover its position, clocking heavy losses that they weren’t keen to reveal. Melvin Capital was bailed out by Point 72 Asset Management and Citadel LLC, who collectively infused $2.75 billion. While official numbers aren’t public, estimates claim that Melvin Capital might have lost as much as 30-60% of their portfolio YTD. To put the extent of the Reddit fuelled tug of war into perspective, Ortex Data, a global financial analytics firm claimed that Wall Street shorts might have lost as much as $70.87 billion YTD (and we are only a month into 2021) following rallies in heavily shorted stocks.
The Aftermath
As of Jan 28, 2020, GME has plummeted 40%, and is now selling at “GameStop resale prices”. The downturn is most likely a direct cause of trading restrictions enforced by Robinhood and other prominent brokerages to protect retail from “unprecedented market volatility”. Many investors also accuse Robinhood of automatically selling GME shares “to mitigate portfolio risk” an act that indisputably goes against Robinhood’s Customer Agreement.
With Citadel (yes, the fund that bailed out the shorts) clearing 60% of Robinhood’s trades, one wonders if strings were pulled to curtail volume from retail investors.
Just visualize a tug of war between Reddit and Wall Street with new Redditors constantly storming through the door to lend support, and now Wall Street closes that door.
The market volatility also sent US indices tumbling, the Dow and S&P 500 shed around 2% each.
GME is likely to witness more erratic price spikes as hedge funds work tirelessly to cover their positions and reddit finds ways to de-hinge the door. Consequently, with the bubble intensifying, the possibility of the entire situation rebounding to hurt retail is apparent and concerning.
A Rookie’s Viewpoint
Trading is undergoing a major overhaul in approach, fundamentals are being left behind and sentiment or “noise” is ruling the market, with more investors flowing in the trend is likely to continue. This is the new normal.
Now highlighting concerns and providing my perspective, previously in a blog I hypothesized the possibility of Reddit fuelled retail disrupting markets via zero brokerage platforms on the macro level. And just 10 months after the Hertz escapade that hypothesis is turning true.
However, just before we blatantly start accusing retail of ruining efficient price discovery, it is essential to consider the preconditions to the Reddit fuelled squeeze. The plan worked because Wall Street was recklessly leveraged and therefore, the alleged “market manipulation” or “disruption” by retail would be inconceivable without the 140% short-float on GME. Therefore, it becomes imperative to argue if the market should allow for extremities like insanely high short-floats, potential “naked shorting” (the practice of shorting stock without owning it or being able to prove concrete future ownership, although made illegal in 2008, continues to surface unregulated), and if the answer is yes because the markets are “free”, then the same rules should apply to retail and investing should not be restricted.
The episode did not eventuate because “Reddit kept buying a stock”, it surfaced because hedge funds made GME (and others) highly susceptible to volume, Reddit then bestowed that volume.
While both parties indulged in unscrupulous trading practices, Wall Street was simply outsmarted at their own game, ultimately prompting them to close their “streets” on retail. This evidently gave them the muscle to tank GME and the affiliated stocks, cover some shorts, and make those balance sheets immaculate again.
With the Reddit movement gaining momentum from diverse backgrounds – investors, politicians (including AOC and Donald Trump Jr., Reddit really possesses the power to unite), and obviously Elon Musk (Melvin Capital was a Tesla short), this battle has morphed into a much larger fight against petty Wall Street tactics, a fight for equal distribution of power and wealth in the markets.
Furthermore, these events will hopefully work to ensure a more robust regulatory structure that advances the legitimacy of the markets while taking into consideration the growing influence of retail and the risk/leverage heavy stance of Wall Street.
With the Robinhood IPO around the corner and a renewed boost towards decentralization, things surely aren’t looking sunny for Wall Street.
For a wholesome ending,
Cover image credits – Aditya Kumar